1031 Exchange for Real Estate Investors (HUGE TAX SAVINGS!)

He’s actually the lead 1031 exchange consultant for Plenti Financial. It’s a group that we use here at Anderson. They’re one of the largest 1031 exchange companies in Southern California. Aaron has assisted hundreds of real estate investors just like you in evaluating their real estate investments and consulted on deals ranging from $100,000 all the way up to $100 million. With that, it’s a real pleasure to have Aaron on board. Aaron, how are you doing?

Aaron: I’m doing great, Clint. I appreciate it. Thanks for having me here. 

Clint: Yeah, it’s going to be great. I’ve been looking forward to this because there’s so much to dive into when it comes to 1031 exchanges. There’s a lot of people out there that talk about the basics. As I stated, I want to go deep. I want to talk about some important subjects such as cost segregation, how that affects the 1031 exchanges, joint ventures, build the suit, and things like that.

Before we get into that, maybe you could tell the viewers a little bit about Plenti Financial, your background, and then let’s move into just the basics of a 1031 exchange. If there’s some viewers that are joining this and watching this for the first time, they’re wondering, I’ve heard about that, but I don’t know what the hell it is, if we could just briefly touch on that and then we’ll go deep.

Aaron: Sure. I understand that. Yeah, and we do hear that quite a bit. Plenti Financial, we’re what’s called a 1031 qualified intermediary or accommodator. Those are interchangeable terms. We have over a 40 year history here. The owner’s been here with this office over 20 years. We’ve been helping real estate investors all over the country, all over 50 states. We consult with quite a few realtors, CPAs, attorneys. We always try to help clients with a strategy before they get involved in their transaction because as you mentioned, not too many are fully aware of 1031s and how exactly they work.

It is a nice tool that every investor needs to know about and apply in their business so that they’re not losing a large chunk of their proceeds. When they sell an investment property, it’s within the IRS tax code to be able to sell an investment property, buy the replacement investment property, and not lose a large chunk of their profit, which can be 30%-40% in the process. 

Clint: Generally speaking, with setting up a 1031 exchange, if I have a property and I’m considering selling it, then how does that work? What should I do if I want to get involved in a 1031 exchange?

Aaron: Sure. Excellent. The first thing would be to be consulting with their CPA and with a qualified intermediary so that we can go over all the proposed transaction information. As far as setting it up, it does need to be set up before they actually close. We’ll talk about some of the timelines, but for sure it does need to be set up before they actually close on their property. In that way, the escrow agent or the closing agent, their attorney knows exactly what to do at closing so that it qualifies and as part of the exchange. 

Clint: If I have my property under contract right now, I haven’t yet closed, and I’m three days out from closing, could I still do a 1031 exchange?

Aaron: Fortunately, you can. We have clients all the way up till the day that they’re closing call in a panic because they didn’t realize they needed to set it up ahead of time, and we accommodate those. We don’t recommend it, but for sure we can get it set up within just a few minutes actually to make sure it’s done before the funds are actually dispersed.

The biggest challenge with that is if it’s not set up before closing, and those funds are dispersed to the client or to the exchanger, that’s considered constructive receipt by the IRS. They’re going to be taxed on that money. Part of the exchange rules is it has to all be set up. There’s a couple things on the settlement statement that need to be done. When those funds are dispersed, it’s going to come to the qualified intermediary to hold, and then it’s sent over to their closing agent to close on their replacement property.

Clint: Okay. If I was someone considering selling a piece of property right now, and maybe I didn’t know that I wanted to do a 1031 exchange, wouldn’t it be then wise just to structure it as a 1031? If I get involved with this and I can’t find replacement property, or I decide I’m just going to take the funds and I’m going to go buy a boat, I can back out of this at any time, is that correct?

Aaron: Yes, that’s correct. It’s always wise to do it just in case to give yourself that option. That’s one of the misconceptions. When people just try to go it alone and read online, they see that they have 180 days to buy replacement property, but that’s only if they had already set up the exchange before they closed on the sale property. Again, once they close, they have that money, and then they try to exchange, they don’t have any chance.

They can look at it as a little bit of insurance, so to speak. It’s like capital gains insurance. If you’re not sure what you’re going to do, just go ahead, set it up, and give yourself that opportunity. Otherwise, you won’t even be able to do it.

Clint: Yeah, all right. Let’s say I have a piece of property, it’s valued, I sell it for $800,000, and I have $400,000 debt. After the loan payoff, there’s $400,000 that is held by the intermediary to be rolled into the new property. What do those numbers look like? When I start looking for a piece of property, I believe you have 60 days to identify if you can touch on that. What type of property should I be looking at price wise to make sure I’m not going to be taxed?

Aaron: Sure, absolutely. Let’s start with really the basic rules of not having to pay that capital gains tax, because it is quite common right now. Somebody may have just bought a property a couple of years ago for a million dollars, and now it’s appreciated so much by maybe double. They’re selling it for $2 million, which sounds great, but they’re going to have that $300,000-$400,000 tax hit on that profit if they just sell it without exchanging. 

What would happen is there are two basic rules if they don’t want to have to pay that capital gains tax. First, they have to take all of their proceeds, all the equity out of that sale and put it into the replacement property. The second part of it is they need to buy equal or greater value than what they sold.  When they read up on that, they’re going to hear about the debt replacement. In your situation where you have a $400,000 loan on an $800,000 property, they again have to buy $800,000 property or higher in order to not have tax.

Usually, they’re going to have another $400,000 loan to make that happen. That’s what that replacement is talking about. However, if the person has cash, they’re looking to get a free and clear property, and they don’t want to deal with a mortgage, they definitely can bring in cash. The main rules are that they’re taking any proceeds that they’re getting out of that sale, putting it into the property, and also that they’re buying equal or greater value than what they sold. Those two things will mitigate that capital gains tax bill.

Clint: Okay. What I’m hearing, and I hope everyone else is well, is that just look at what you sold the property for. If you’re trying to figure out how much you need to roll into replacement property, whatever you sold it for, that’s what needs to be rolled. That’s a simple way of summing all that up.

Aaron: That’s a very simple way. That’s exactly how we try to help people simplify everything that they’re reading to understand it. Yup, replace what you currently have with your new property, or it could be multiple properties. As long as the total of everything that you’re buying is equal or greater value than what you sold, then you’re going to be okay. 

Clint: It doesn’t matter how you put that deal together. You can come in with cash, you can come in with loan. Maybe you’re trading your dog to get this property, but as long as you’re getting it for the same price or more, you’re clear.

Aaron: That’s correct, then you’re going to be clear on that. That’s exactly correct. 

Clint: Okay. Now, since we’re on that topic of rolling money in, I do want to talk about something here that does come up, and that is for people that have cost segged their properties. This is really popular now with bonus depreciation, where they’ll go in and they’ll break up their property and say, all right, the useful life of this portion of the asset was 5, 7, or 15 years, and I’m going to expense it out with the bonus depreciation 100% this year, if it was a couple years ago, or 60% now. When we’re doing an exchange on a property that I’ve done a cost seg on, let’s say I’ve pulled out $200,000, it’s my understanding that portion  is taxable to me unless I can find replacement property that has equal property inside of it, landscape and all that, that it equals what I did on the original property, cost seg. 

Aaron: Yeah, correct. You always need to be finding equal or greater of what you did that to. You got to be keeping track of the tax basis along with those as well, because that is rolling into the new property that will just roll over. In order to not have the tax, it’s all about exactly replacing that part of it and making sure it’s equal or greater value for sure. 

Clint: The depreciation is what we’re getting at here. That can trip some people up then on a 1031 exchange.

Aaron: Yes. In fact, when we say the total capital gains tax can be 30%-40%, that trips a lot of people up. They’re usually quite surprised wondering, where did we get that number from. They’re thinking capital gains is just 15%, which when they read up on federal tax rates, they just see 15% and think that’s it. But in reality, that can be 15%-20% depending on their tax bracket.

They have the state capital gains rate, which here in California can be 13.3%. But then that depreciation, everything they’ve been writing off in depreciation, which has been nice through the years, but when they go to sell, the IRS wants 25% of that back. It’s a depreciation recapture. All of that is the total of what they’d be owing the IRS if they just sold, and that easily equals to 30%-40% of their profit. 

Clint: Got it. When you do roll into the new property since you’ve already depreciated it, you’re rolling your existing basis. If I sold a property at $800,000 and I had a tax basis of $200,000, then in my new replacement property, my tax basis will continue at $200,000 unless I buy up.

Aaron: Unless you buy up. You said that exactly right. Yeah, it’s going to roll over. If they just buy equal value, it’s just going to roll over and continue on with that same basis. If they buy up and have additional value, that additional value would be added onto the basis. This is where it’s really important for their CPA to be involved ahead of times that they know what they’re doing and can be tracking that for them. 

Clint: All right. Here’s the question that I get a lot, and that is, what about on the replacement side? If I’m selling an asset, maybe it’s $2 million, it’s commercial, and now I want to buy residential, the first question for you, (1) is that a like kind going from commercial to residential? (2) If I sell an asset at $2 million, how many replacement single family homes am I able to close/exchange into?

Aaron: Excellent questions. I get these all the time myself. That like kind part with the IRS rule trips everybody up. We get people saying that all the time. I’m selling a duplex, but I don’t want to buy another duplex. They think they’re pigeonholed into that. Oftentimes they just decide not to exchange and they’re paying hundreds of thousands in tax unnecessarily.

The like kind with the IRS, all that’s referring to is just, it’s an investment property that you’re selling and you’re buying another investment property. That’s the like kind, investment property to investment property. Within that, the type of property itself does not matter whatsoever. If they’re selling that duplex, they want to put it into a single family, they want to put it into an apartment building, they want to put it into a commercial property, as you mentioned, you want to go from commercial property to residential, even vacant land is considered investment property, triple net lease properties. DSTs, Delaware Statutory Trust, which are more of an investment type of situation, but all of those are allowed within the 1031 exchange rules as long as it’s being considered and used as an investment property.

Clint: Okay. In that particular context, how many properties can I buy?

Aaron: With that, again, they can buy any number of properties as long as the total value is equal or being greater than what they sold. We’re seeing that all the time. For instance, here in California, people are selling. Maybe they’re getting a million or two million out of a property, and they want to diversify. They’re taking it to Texas, Florida, or where have you, and they’re buying three, four, five, even sometimes 10 different properties. They need to level up all the value of what they’re buying as long as that’s equal to what they sold, then they’re going to be okay.

Clint: What’s that identification rule that you have? Three properties. If I want to buy 10, how do I identify 10 if I’m limited to three? Maybe I misunderstand that.

Aaron: Yeah, a good question. Actually, we missed the timeline part, so I’ll explain that a little bit. With an exchange, you have a timeline. The total of it is 180 days. That starts from the day that the property sells. You have 180 days to close on your replacement property, or if it’s multiple properties, they all have to be done by day 180. 

The first 45 days of that, though, is the identification time. By day 45, if they haven’t closed on replacement property, you’d literally turn in a list of potential properties, and then you have to close on ones on that list per the IRS. That’s a good question, what you’re asking.

Deeper than that, if you’re going to turn in a list,  how many can you put on that list? Most will put up to three. The IRS allows up to three at any value. If you sold for a million and you want to list three at a hundred million, you’re totally fine. However, if you list more than three, that’s where there’s going to be a cap. The IRS will now cap the total value of all those that are on that list at 200% or double of what you sold.

If somebody sells for $2 million, the total of everything they put on there is going to be $4 million if they’re going over three properties that they’re identifying. In that case where they’re trying to buy 10, usually they’re buying a bunch of maybe $200,000 properties. In that case, it’s fine. But they might run into some trouble if they’re trying to buy higher end properties, several of them, and they only sold maybe a $500,000 property. 

Clint: Okay. How about if I want to buy a property and this property needs a lot of work? I’m getting a deal on it. If I sold a property, going back to my $800,000 example again, and I find replacement property that is $500,000, but it needs to have a whole new roof, landscaping, windows, a new driveway, so I estimate that I’m going to put into that property several hundred thousand dollars to rehab it just so that I can rent it. How does that work in an exchange?

Aaron: Sure. There’s an excellent way of handling that. It’s called a construction or we call it an improvement exchange. The funds can be used for improvements. What’s happening in that situation, they’ve sold for $800,000, they find this great replacement property, it’s only $500,000. If that was all they did, again, by those rules we’ve discussed, they’re going to have some tax between the difference of what they bought and what they sold.

In that situation, they have some money still sitting in the exchange account. Even if they don’t have money because they had a loan on it, they still have this room that they can send in to go towards improvements. What happens with an improvement exchange it’s really neat. Before they close on that purchase property, the accommodator, the qualified intermediary, which is us, actually take title to that property when they initially close on it. We have all the agreements in there in place, escrow and title.

We’ll understand they’ll get some additional information from us, but we’re holding title now during that 180-day period. What that does is it allows the exchanger now to use the funds in the exchange account to do those improvements. As those improvements are being paid out of the exchange account, it’s being tacked on to the value of what they bought. Now they’ve bought a property for $500,000, they’ve done the $300,000 in improvements, and now we have to deed that property back to the exchanger by the end of the exchange. By day 180, it has to all be deeded back over. Now they get the new value, that $800,000. They got improvements and they’re not paying the capital gains tax. 

Another cool thing about that is all we’re really looking at is that the money is being paid out 180 days. If somebody sells them, they buy a property, and then you’re going to try to improve a property, it might be very difficult to get all the improvements done within that short amount of time, but it’s the money being paid out of the account is what counts. We have invoices come in, we have money that goes out. As long as that money has been paid out by the time we deed it, that’s all going to be counted in the exchange. 

Clint: Okay. Here’s a strategy. Maybe it doesn’t work. Let’s assume that I have a contractor that I know and trust. It took me 120 days to close on this property, but the rehab is going to take another 120. I’m going to be 60 days past my 180.  Could I negotiate with the contractor to do a fixed bid contract prepayment upfront for all the improvements? Have you paid the contractor to do all the improvements, even though they haven’t been all completed yet by the exchange rate? And would that qualify then?

If I had that $300,000 and I said, all right, boom, here you go, contractor, here’s a full $300,000, I know it’s going to take you a while to get this done, but as long as it’s out of the account, it’s in the contractor’s hands, does that qualify?

Aaron: There you go. The key on that you said, Clint, was that it’s a contractor that you know and trust. That is between you and the contract at that point. Yes, that can absolutely count. The nice thing is this isn’t like a construction loan. You’re not going to have a lender coming out and inspecting the property, making sure everything’s been done. We’re not looking at appraisals and that type of thing. Literally, if we have an invoice that comes into the exchange and that money gets paid out of the exchange, yes, absolutely. That’s going to count. 

Clint: How about if I ran it to an escrow if I paid it over to the escrow for the benefit of the contractor?

Aaron: As long as we have an invoice and we need the money being wired out of the exchange account, then that’s going to work. 

Clint: Nice. Hope people are picking up on that. Okay. Another thing I’m thinking about. Let’s assume that my father has a building, he’s tired of operating this property, and I want to buy it. Can I do that in 1031 exchange from my asset into his asset?

Aaron: That’s going to be a related party transaction. There’s going to be some rules attached to it depending on who you’re buying from, who the related party is, and then who you’re going to be selling to. In most cases, if you’re buying from a related party, the IRS is funny on these rules. I didn’t make them up before you start asking why this is. If you sold to a non related party, which is usually quite common, you just put it on the market, you don’t know who bought your property, now you want to turn around and buy from a related party, that usually isn’t going to work in an exchange. That’s called a related party exchange.

For whatever reason, with the IRS, if you sell to a related party, and now you’re going to buy from a related party, if everybody holds onto their property for two years, that can work in an exchange. This is where someone’s really going to have to get involved with their CPA, perhaps their tax attorney for specific guidance on their situation. The IRS has some rules around that because they’re afraid of they call it cost based shifting. Perhaps they’re getting special treatment from a family member. They’re going to have some rules around that. Each situation, that’s why we want to talk to the person up front and make sure they understand it. 

Clint: What I want people to understand though is that’s a potential. Don’t walk away from a deal just because you’re dealing with a relative, but you can possibly put this together, which then makes me think as well, I’ve heard about incidental. If I’m buying a property, and I’ve always wanted to own a Kubota tractor, and I’m going to need that Kubota to do some trench and work and move dirt around on the property for landscaping, isn’t there a rule where I could buy a Kubota and still wrap it under the exchange?

Aaron: What the IRS is going to look at if they ever do an audit would be different than what we might look at, but it does have to be real property basically. That’s going to be wrapped into the contract somehow and included. That’s going to be fine. Usually, something that’s not real property, for instance, if somebody is buying a business and that includes the real estate, usually those amounts need to be separated out.

Clint: There was an incidental rule. If it’s less than 15% of the thing, you could classify it as an incidental and roll it up under the exchange as long as it’s part of the asset or community.  Maybe I missed it. 

Aaron: That doesn’t come up. I’d have to refresh my memory on that part of it. We rarely see that come up, but there are ways of putting that in there. That’s where we make sure that they’re checking with their tax attorney on that part of it with what they’re putting into the contracts that it can all be classified as real property.

Clint: Perfect. Look for properties that have a nice, 32-foot grady white-ish, and make that part of the deal. It just comes with the garage.

Aaron: There you go. Exactly. 

Clint: All right. Now, I’ve done my exchange, I’ve closed on the new property, and now I’m looking for some funds. I did all cash. Back to my example again, $800,000, there was no debt on the original property, I sold it for cash, I take that $800,000, I buy replacement property, when can I go and do a cash out refi on that after I’ve closed on the replacement property without there being any tax consequences?

Aaron: Yes, excellent question. Just for those watching this, the reason for that question is a lot of times people are always asking, when do I ever get money out of this, because if you long as you keep selling and exchanging, you’re not going to pay that tax. But then they’ll think, oh, wait a minute, how do I ever get cash out of this? One of the best ways is to put that cash into the property, buy it for cash, and then turn around and do that cash out refi. It’s not a taxable event and just do that right after you made the purchase, then you’re fine. We’re always advising for that.

There’s basically two ways. (1) Pulling out cash boot out of the sale. If somebody only needs a hundred thousand or so, they could elect to take it out of the sale and pay cash or tax on that cash and then exchange the rest. (2) The best way is putting it all into the replacement property after it closes, just turn around, and do a cash out refinance. Now you have that cash and you don’t have to pay the tax. 

Clint: Okay. What happens if I find a replacement property in Dubai? You may not know this, but we have an office in Dubai. We work with a lot of investors or now investing over there. If I’m here in the States and I want to go out to Dubai and buy a property, can I exchange into that property, and would it qualify?

Aaron: Good question. Again, that goes back to the like kind rule as far as property. We discussed it doesn’t affect property type. However, it will affect international property. Like kind also will apply to something sold within the United States, we need to be replaced within the United States. Now, if they sold a property international and then buy international, that is like kind. But crossing the borders going from United States to international, that wouldn’t be considered like kind. 

Clint: Interesting, yeah. Okay, that’s good to know. Since we’re asking these questions, what happens if I’ve got a partner? A lot of people will joint venture on deals. Let’s say they go in and they buy a multifamily, they own it in a limited liability company, and they decide they want to do a 1031 exchange. Can you touch on what they have to do in order to make that work out for them?

Aaron: Sure. Yeah. This also comes up all the time. I just had a client the other day asking the exact question with this scenario, where he had invested into a project with a developer. I think they’re building 10 homes or something like that. They’re getting them pre-sold and he’s lining things up. What happens with that, since he’s invested, what we have to ask is who’s actually untitled to those properties. In this case, it’s an LLC, so it’s like a joint venture. You have all these investors that have come in, but the LLC actually owns the property. 

Again, within an exchange, what the IRS looks at, they call it continuity of taxpayer. The taxpayer that sells is the one that’s going to be reporting that on their taxes and reporting the exchange. If an LLC owns the property when it’s sold, it’s actually the LLC that’s going to be buying. What we’ve explained to him is if he wants to be able to exchange just his portion, I think he might have been maybe a 10% investor or something like that, he’s got to negotiate being put on title as what’s called a tenant in common. He’s got to come out of that LLC. He’s actually got to be on title with a percentage.

That percentage is going to come out at the close of escrow. He’ll be able to have his own 10% that he can exchange out and make sure that now he’s just replacing the value of his 10% that was sold. That has to be done ideally six months or more in advance, just that the IRS doesn’t look at it as manipulating things and not have to pay tax. That happens a lot, where somebody has to be dropped out of an LLC to build an exchange. It’s called a drop and swap. They get dropped out, then they swap, and do their exchange.

Clint: You just said something there. You said six months in advance.

Aaron: That would be ideal. That’s why we have to be thinking of this ahead of time. We have clients that do it right before because they’re already in contract and never asked about it.  We can’t tell them exactly what will happen, but we just make them aware. The IRS could ask about that. Ideally, plan ahead. If you have to be dropped out of an LLC, do it plenty of time ahead of time.

Clint: I’ve had discussions with clients before about 1031s and they said, I bought a property, I’ve held on it for six months, now I want to sell it under a 1031, and my tax advisor said it wouldn’t qualify. I’ve always taken the position that that’s incorrect advice, that it’s an intent based test. If you bought the property with the intent to treat it as an investment and you held onto it for six months, you didn’t hold onto it for a year, somebody came along and said, hey, I’m going to give you five times what you paid for that, and you sell it, it should still qualify. What was your intent when you bought the property? How did you treat the asset? 

Correct me if you differ on this opinion. The idea that you have to hold something for an entire year before it becomes investment property, I’ve never read that in the code. It doesn’t say you have to hold it for a year, it just states what was your intent in acquiring the asset. Did you intend to hold it as an investment, or was it an inventory?

Aaron: Yup, I’m explaining that to people all the time, Clint. Yeah. That’s a huge misconception. I don’t know where one year hold even came up, but that’s exactly right. When somebody asks me how long do I have to hold property, the IRS doesn’t say. There’s nothing written in there where you’re going to have a number of months, number of years. They’re getting this advice just based on maybe safety, let’s just be conservative. It’s the intent.

You’ve held property as an investment. What they’ll say is you’re going to buy property that you’re going to “hold” as an investment property. That’s it. If you held it for a month, two months, now something better came along, or you realized, oh, that wasn’t the right property for me, but you show that the intent was to have it as an investment property, then sure, go ahead, sell, and exchange it. 

Clint: Okay, let’s flip the script now. I’m not selling, I buy. I buy a property today and I’m thinking, you know what, I need to free up some cash, I’d like to sell a piece of property to get that cash freed up for this acquisition. Can you do a reverse or something? I forget what it’s called, but rather than buying first or selling first and buying, can’t you buy then sell?

Aaron: Yeah, you named it. It’s called a reverse exchange, and it’s just for that exact purpose. If you’re going to buy a property, if you found that perfect property, and you don’t want to pass it up, you don’t want to take that chance of missing it, and you have the cash, a loan, or the combination of the two to be able to close on it without needing to sell, then by all means, you can buy that property first. Now that 180 days within the exchange, you have the whole 180 days to turn around and be able to sell your property tax free.

The way that works, again, it takes a little bit of extra work just to set up ahead of time. As long as a client knows that it’s a possibility, let us know so that we can all be set up. What happens is the accommodator, again, needs to get involved by holding or the IRS calls it parking one of the two properties. They can’t own both properties at the same time. If they just bought that property, and now they own the replacement property and the sale property, it’s too late. We step in, we’ll park one of the properties, either the one they’re buying or the one that they’re selling, and that allows them then now to exchange.

When the property that they’re selling closes, that money comes to us first as the accommodator, and then it can be reimbursed to them tax free for the purchase that they already made it. It helps them to be able to lock up the perfect property when they see it, and it takes care of that whole 45-day rule because they already bought the replacement property, so now they don’t have to worry. They just buy, now they have the whole 180 days to sell.

Clint: There are two ways you do it. One is you just buy it, financing, cash, whatever. The title is held in your name when I buy it?

Aaron: Correct, yeah. We could have it held in our name, or we can bid the sale of property. One of the two would have to be held by us. Correct.

Clint: If you hold the property that I just purchased, then the property that I’m selling, who holds the proceeds from the sale of that? Does that come to you?

Aaron: Correct. They’re buying initially with their own funds. You weren’t involved in those funds. When they sell now, those funds are going to come straight to us from escrow or their closing attorney. Instead of them sending it first to the client, they just send it to us first, and then we can turn around and send it back to the client to reimburse them for the funds they put in. 

Clint: On that type of deal, I don’t even need you for the buy, I just need you for the sell. 

Aaron: As far as the fund is part of it, but yeah, you do need us though to have it set up and have the titling and everything already arranged. We have to have the whole exchange set up. For the funds part of it, that’s correct. Yeah, the funds are not going through us for the purchase at that point. 

Clint: When I close on that property, say I’ll buy a building tomorrow, do I close in your name or I close in my name? 

Aaron: We set it up one of two ways, our ways that we like to set up to make everything streamlined, because what can happen is if the property they’re buying is held in our name, then they’re trying to get a loan that they can run into issues. We’ve really streamlined the process to where what we do is we have a deed. They’ll have them draw a deed on the property they’re going to be selling. It’s an unrecorded deed.

We have contracts, leases, the whole bit to where they stay in charge of the property. They still manage it, they can sell it, they can do what they want. We get a deed, it’s unrecorded. Now that satisfies that property is parked and allows them to close on their purchase, and we don’t run into any financing issues and so forth with that. 

Clint: Could I also do this? Let’s assume that I  don’t close, I just negotiate with the seller. Listen, I need 180 days to close on this property, I’ll give you 10%-15% earnest money, then I don’t even close on it until I get the exchange proceeds from the sale, then that goes to the seller for closing, and then I get reimbursed for the money I put in. Would that qualify as well? 

Aaron: In that case, it goes by which one is closing first. If they’re still closing on the sale first, then that’s still a standard exchange. That’s going to come to us first. It’ll all go to escrow to close on the purchase. Whatever money they put in for their deposit, so they put some money down to hold as a deposit, that can get reimbursed in at that point out of those closing funds.

Clint: Got it. I would sell my property, I’ve got 180 days to close, I negotiated with the seller, then I just turn around and identify that property that’s what I’m closing on, and then we go to closing on that.

Aaron: That’s exactly right. That’s the most ideal way. If you can find a seller that’s willing to make a contingent sale and give you time to close on your sale, that makes everything a lot more streamlined, of course, but yeah, that’s exactly how that would work.

Clint: Okay, interesting. Now, how about if I want to sell multiple properties and roll them in? How does that work?

Aaron: Right, exactly. We’ve discussed somebody buying multiple properties, of course it’s fine. There’s a little challenge that can come up if somebody’s selling multiple properties and put them all into one, or into a few, which is fine. The challenge is that each one of those sales is its own exchange, and they’re each going to have their own timeline. Are they going to be able to sell them all at the same time or maybe within a couple weeks of each other, because they’re all going to have that 180-day timeline with the 45-day identification time. They got to start then really with the timeline of the first exchange, because if they take too long, that first exchange is going to get blown. 

A great way of handling that, if the sales are going to be spread out a little bit, is we can combine the exchanges. It’s a great tactic of doing a standard exchange to set up that first or maybe two sales at the initial ones. We set up a standard exchange for each of those, and then they can go ahead and buy their replacement property. But when they purchased that property, we set up a reverse exchange.

What happens when they close on that reverse, that’s going to give them a whole new 180-day timeline from the close of the purchase. Now they can go finish selling their other properties. That’s done quite a bit in those circumstances. It’s like a combo exchange.

Clint: What I’m hearing is you roll part of it in, you come in with a loan or cash, and then that gives you the 180 days to go out and sell the other stuff to get reimbursed and pull it all together.

Aaron: That’s exactly right. It’s buying time. Theoretically, you can end up doing this for a year. You have 180 days from the time you sell your first property to close on the purchase and make that into a reverse exchange, another 180 days. You just bought yourself a whole lot of time to be able to complete those sales. 

Clint: Interesting. How about if I wanted to buy a personal residence? Can I sell investment property and go out and buy a home? 

Aaron: This comes up at times, especially if they’ve been investing for a long time and they want to find that perfect retirement home. Here’s the key to that. We’ve talked a little bit earlier about intent. The IRS is going to look at what your intent is. The best practices to buy that home that you really like, that you want to live in down the road, but you need to show it as an investment property at least on the first two years of tax returns, list it for two years. At that point, something came up in life, something changed, need to move into it, then that’s the time to do it. You can’t show the intent when you make that purchase that was your original intent, but list it at least on two different tax returns as an investment property first. 

Clint: Here’s how I see creatively you could do this. You build the property. We talked about that earlier. You run into time issue there because if it builds more than 180 days, you only be able to roll in whatever you can build.

Aaron: Whatever you can build or however much. Again, if you have that contractor you trust, you don’t mind paying them up front, so that’s a possibility. 

Clint: All right. How about this? You don’t want a bunch of strangers in the house that you’re building to be your personal residence, so you rent it to your daughter, your son, or you rent it to your corporation. You show income coming in that comes up on your 1040, right?

Aaron: Yeah, corporation is the best bet on that. You can definitely rent to family members. We get asked that a lot. You definitely can. We always recommend have a rental agreement and be renting around the market rate for rents. If you’re giving them a sweetheart deal where they’re just paying for electricity, the IRS could question if that’s truly an investment property. Yeah, absolutely, that can be a way to have that managed to have somebody that you know and trust taking care of your property for those first two years. 

Clint: I hope people are picking up on this. We just gave them was a strategy where you sell an investment asset, you don’t pay any tax on that, and roll it into your personal residence that you’re eventually going to move into. Then when you move into it, you sell your primary residence right now and you exclude up to $500,000 under Section 121. You just put that money in your bank account. You’re actually taking advantage of two provisions here in the Internal Revenue Code to not pay any tax. The only caveat, as I understand it, is you’ve got to live in it for five years before you can do a 121 on that property.

Aaron: Yeah. The 121, that’s the personal residence. It’s two out of the past five years, and it’s any two of the past five. If you’ve lived in it two out of the past five, you can take that $250,000 as a single person or $500,000 for a couple. Here’s a nice thing about that. If you’re really planning that one out too, before you sell it, if you’ve been living in it, you can move out of that and rent it for a year, show it on your tax return as an investment property, and now you can exchange the whole thing without paying the tax. Again, it takes a lot of planning ahead of time, but just realizing these are options. Somebody can work the whole transaction without paying that tax bill. 

Clint: Yeah. I’d put a caveat on what you just described. I take it to a little different level. What I like to do is I tell them, move out of that house after you’ve sold it to your S-corporation. You enter into an installment sale with your own S-corporation, then you can increase the tax basis in that property for a future sale when you finally decide to sell it, and then you elect out of the installment sale reporting. You still get the $500,000. You pick it up right away, you elect out of the installment sale so your basis goes up.

There are so many different ways, like you said, to work these deals. Most of the time, what I’ve found is that people don’t reach out to yourself, calling you, calling Anderson before they do this, and then our hands are tied because they’ve made some mistakes or they’ve already taken some action that we can’t unring that bell, which brings me to this, and that is Deferred Sales Trust. I’m sure you’ve come across that strategy. What are your thoughts?

Aaron: That one, I haven’t dealt with. You have to fill me in a little bit, Clint. That one usually has fallen from what I’ve seen outside of our 1031, but you can fill me in on that one for you.

Clint: I’ve had individual clients approach me on this before and they say, I’ve got this company that I’ve met. A lot of them are out of California or Utah. The strategy is I then sell them my house on an installment sale, they then buy the house, and they turn around and sell it to the person I intended to sell it to. They collect all the funds. Since I haven’t received the funds, they hold on to those, they invest them, and then they pay them back to me over time. It’s a way for them to sell a property without having to buy a replacement property. Typically, those proceeds get reinvested into something else entirely. Maybe it’s going to go into crypto, the market, or something like that.

Aaron: Right, yeah. When we tell them, hey, we’re going to talk to your tax attorney, that’s exactly what you’re there for. They understand they have all these other options without the 1031 as one realm, and then they have plenty of other options as well to go. Absolutely.

Clint: Yeah. I was just wondering if you ever came across that because I look at it as a disguise sale. Going back to what we talked about earlier, your intent on this transaction is to really never sell it to this party. Your intent was to sell it to the other party that they’re selling it to. You’re just a straw man to get it taken care of.

Aaron: Yeah. 

Clint: That’s great. Like you said, there’s a lot of stuff here. What are some of the major mistakes that you’ve seen, that real estate investors have made that blew up their exchange possibility?

Aaron: The first one, as I mentioned, ones that never set up an exchange really. They’ve already sold, they have the money, and then they turn around and ask. That’s just number one. They don’t even have an exchange, unfortunately, and they’re going to pay the tax. The second ones are some of the ones we’ve talked about, where they’re just not buying enough property, or they’re misunderstood. They’re thinking that they get to take their initial investment out of the sale property when they sell. That’s very common mistake. Maybe they put $200,000 down on a $500,000 property, and now they’re selling for a million. They think they’re going to get that $200,000 back, and they just exchange whatever proceeds are in the exchange.

Some will never believe us, even though we try to tell them, but they’ll have a tax bill the following year when they go to report that sale. Those are usually some of the biggest mistakes that we see, just ones when it comes to the reinvestment, not buying enough property and not understanding, that if they touch any of the money, even though they put money into the deal, the IRS looks at it as they’re pulling out of the profit first. They’re going to get taxed on that. 

Clint: The way you pull money out is via a loan. Go to a lender and you get a loan.

Aaron: That’s exactly the way to do it. That does not trigger a tax bill unless you sell. 

Clint: Got it. All right. There’s some talk now. I know Biden proposed changing the 1031 exchange rules in his budget proposal that we now limit it to $500,000 or a million per couple per annum. You can only defer. If I had $2 million dollars in gain built into a building and I’m single, I can only defer $500,000 of that. The rest would be taxable. Have you heard this before? Have other administrations tried to do this? What do you think the likelihood of something like that passing? 

Aaron: Yeah, that’s a good question. It’s not the first time that it’s been seen out there. It seems like it’s something that almost is just automatically put into bills to make it look like something’s being done about taxes or what have you. It’s usually always put in there, and it’s usually always something that comes right out. The reality of the situation is the effect that would have on the real estate market, and that’s known. It would just bring everything to a halt and just be horrifying.

The cataclysmic, what would happen if everybody just stopped selling investment properties, because that would cause so much tax. Everybody uses it. It’s part of such large plans, even by the politicians themselves on writing those bills. From what we’ve seen from history, it’s usually always starts off in the bill. It makes them feel good like they’re trying to do something, but it usually comes right back out. 

Clint: Yeah, that’s been my take as well. I’ve been telling people, hey, they’re just trying to buy votes, and so they’re going to throw that stuff out there. People think the rich real estate investors need to pay more in tax. I’d like to single this out. This has been really enlightening. You’ve answered a ton of questions and given a lot of value here. In closing, is there anything you’d like to say to the individuals that are watching this right now?

Aaron: Yeah, and it’s a little bit of a recap. Hopefully what everyone’s understood is that 1031 exchanges don’t have to be necessarily complicated or be included in the shroud of mystery, not understanding how it works. The key is to go ahead and give us a call or get your strategy team involved ahead of time. Just go through the potential numbers and the transaction. It’s going to clear up a whole bunch of things for you before you get involved and find out at the last minute that something wasn’t done right. That’s the biggest part, just get everybody involved and get your questions answered up front. 

Clint: Awesome. What we’re going to do is we’re going to put a link in the show notes below. If somebody wanted to get a hold of you, they can just go right there and click on that link. It’ll take them over to you. Other than that, thanks for taking the time to come on here today and share with us all your information when it comes to 1031 exchanges. I appreciate it.

Aaron: Sure. I appreciate that, Clint. Thank you so much.

Clint: All right. Take care.